Sleeping with the enemy can be a very dirty but necessary task in order to make meaningful change. But that should not mean going easy. The headlines around APRA’s recent bank stress testing and financial forecasts reflect a common view that essentially all’s fine, the future will reflect the past and a plan is in place for Australia to deal with all contingencies that may arise.
No amount of self-congratulation, hubris, back slapping or dismissive statements about any counter view can alter the position we are now in and the lack of action being undertaken. We may not be Spain or Ireland today, but neither were Spain or Ireland.
Australia’s transition in the last 15 years has been from an economy starting with rapidly rising private debt replacing government debt, double digit net credit growth, a trade surplus and then a transition through the GFC with government stimulus and debt issuance temporarily boosting the economy. Finishing with a last boost of credit growth and the trade boom Mk II but still with a current account deficit to leave us with total private (business and household) and government debt at over 200% of annual GDP. Household credit growth over the period has left Australia with the some of the most unaffordable housing in the world, which severely limits our options for the future.
Both the IMF and the RBA are forecasting an annual CAD of 6%+ of GDP over the next few years significantly adding to the net debt scenario.
The major drivers of ADI, particularly Mega bank, deposit growth since the GFC of increasing government debt, the trade surplus and credit growth are now at an end. These engines of deposit growth particularly foreign buying of A$ government bonds, have allowed Mega Bank to rely less on direct offshore borrowings over the last 3 years.
Therefore with little possibility of deposit growth and governments dedicated to our own form of austerity, the CAD can only be funded by increasing private borrowings offshore. These offshore borrowings must be funnelled through Mega Bank. This is not a choice, as the CAD will cause a decrease in deposits with no corresponding decrease in assets.
Faced with a scenario like I’ve described, it’s not unreasonable to assume that there would be much concern and plans of action to deal with these changing circumstances. Whilst my experience is that there is some action being taken, particularly by the RBA, there really is precious little understanding of both the circumstances and the need for action within Australia’s financial system, particularly Mega Bank. For organisations that are taxpayer supported this is particularly galling.
An open an honest debate on the issues and possible solutions is necessary in order to throw up manageable solutions or the means to mitigate any downside. It’s a must. The argument that discussing possible weaknesses will be a negative and spook offshore investors just does not cut it as a way forward. To do nothing will cost innocent Australians dearly.
On the other hand, why do all the researches conclude that there is little to be concerned about? My analysis says that it’s all about the questions that are not asked, rather than the ones that are. So let’s address some common faults in the stress tests or financial stability analysis.
APRA’s stress testing of Mega bank highlights many unanswered questions. So when analysing these types of stress tests, the following are some important issues to be raised and questions that must be asked and answered for any stress test to be valid.
Firstly, a stress test of Mega Bank should not just be about whether the bank has enough capital to cover losses in a stressed scenario but whether under the stress scenario Mega Bank could without government support continue to fund all its liabilities and continue to provide credit. This is a much more important, although complex question, which also needs to include funding of the CAD as forecasted.
As our esteemed editor of MB pointed out and due to residential mortgages making up 50% plus of the balance sheet, no stress testing of Mega Bank can be seen as valid without a stress test of Australia’s LMIs, Genworth and QBE LMI. The LMIs provide mortgage insurance for the riskiest 50% of Australia’s residential mortgages (about $600Bn) with a capital base of less than 0.8% ($5Bn). If the LMI’s were to not survive a stress test then besides Mega Bank being short on its insurance claims, the bigger question is where is the capital sourced to protect the remnants of Mega Bank’s residential mortgages? Mega Bank currently significantly reduces its risk weighted due to mortgage insurance. Any stress test must provide the capital adjustment for a lack of LMI and an answer to where the extra capital is accessed.
Of particular importance when stress testing Mega Bank are the model assumptions used to calculate the effect of significant decreases in residential house prices. The APRA stress test assumed a house price decrease of 35% and 12.5% unemployment that were similar to IMF stress testing and the actual situation for both Spain and Ireland. However, the results of stressing for this situation produced by APRA and Mega Bank certainly do not reflect the situation in Spain and Ireland. Why not?
My analysis points to a very basic stress analysis being conducted with reductions in house prices simply being used to produce a loss given default number and unemployment used as a stress for probability of default. For example, defaults increase by 70% of the increase of unemployment (12.5%- 5.5% = 7%) that equals 4.9%. The increased default level of 4.9% times $1,100Bn times 35% = around $19bn or 1.7% of the total Mega Bank residential mortgage book. Whilst Mega Bank may have some difficulty with losses of this size, if that’s all there is perhaps its manageable.
Whilst this simple analysis may be more than sufficient for a small well capitalised bank, it’s certainly not for Mega Bank. Simply making an assumption that such a savage reduction in house prices, only those unemployed would default flies in the face of human behaviour and experience in the US (full recourse states) and other countries. In addition Australia’s “ borrower hardship programs” together with regional extremes in house price decreases will guarantee that 35% average reductions will ensure losses on foreclosure certainly moving to over 50%.
Losses on foreclosure on residential mortgages in an extreme but possible scenario of a 35% reduction in house prices, will certainly be much higher and probably approach $30-$40Bn or 3-4% of residential mortgage assets.
During the whole process, Mega bank needs to maintain its balance sheet, credit rating and the ability to fund both domestically and offshore. Having wiped out its total provisions of about $20Bn, would not Mega bank have not only replenish the provision back to $20Bn but to increase provisions at least to the loss levels, say, an extra $15Bn?
Also during the fallout, Mega bank would be required to revisit its internal risk based calculations for residential mortgage risk weightings and capital. On average Mega Bank has around 1.6% of capital against residential mortgages, ie around $18Bn that has kept its return on capital high. Surely Mega bank’s own models would require a significant increase in risk-weighted assets, especially when in the extreme stress scenario the LMIs are not likely to exist? It’s not unreasonable to assume a doubling of risk-weighted assets to, say, 3.2% or an extra $18Bn of capital.
Note that, without extra government support, Mega Bank needs to not only maintain its offshore borrowings but also increase them to fund the CAD and therefore must show strength of balance sheet as it was before the scenario is played out. In which case, the above estimated capital requirements are not fanciful but probably close to reality. So Mega bank in the APRA and IMF scenario probably needs $63-$73Bn of new capital just to cover the effect of the stressed scenario with residential mortgages.
However, neither APRA nor the RBA will rely on that capital being readily available to Mega Bank. The most likely scenario is massive repo of RMBS to the RBA by Mega Bank to replace required offshore funding. Whilst many may be happy with this fall back, it’s not how Mega bank should be stressed nor should it be Plan A.
Mega Bank, in the early part of the scenario would probably be able to raise funds offshore by issuing covered bonds. The problem with covered bonds is that their issuance will exacerbate the amount of capital that Mega Bank will actually require due to the significant weaknesses they cause to the balance sheet through the over collateralisation assets (residential mortgages) sucked in to the covered pool at the expense of unsecured creditors. How much extra capital will be required to cover this balance sheet weakness?
My interpretation of the stress test scenarios conducted may not occur as a matter of fact but it’s not fanciful and is a real probable outcome.